A month ago I wrote investors were missing the big picture about the unusual calmness displayed by financial markets despite several major headwinds building in the global economy. Then, I highlighted the ongoing fiscal crisis in Greece, falling commodity prices, possible interest rate increases by the US Federal Reserve, and concerns about China’s economy. It is this latter issue dominating current discussion.

Over the past week, Chinese stocks have fallen by 20%, US sharemarkets have declined nearly 10%, and Australian markets have followed global markets in posting a decline of 6.4%. Unsurprisingly, the (CBOE VIX) investor fear gauge has nearly tripled as investors display high levels of anxiety and seek protection against further losses following the destruction of trillions of dollars of market value.

The current situation brings to mind the adage of economist Rudiger Dornbusch, who said that: “In economics, things take longer to happen than you think they will, and then they happen faster than you thought they could.”

Some perspective

While recent days have witnessed a sharp sell-off in global stock markets it is important to remember that investment is generally a long-term game. If we look at this recent move in the perspective of stock market performance over the past five years we can see that, even after last week, US stocks have increased by around 72%, Chinese stocks have increased 23% (50% in the past year), and Australian stocks are 17% higher. Of course, the investors who will have lost most are those who have arrived late to the party in China; there is anecdotal evidence to suggest that this year’s sharp increase was driven primarily by uneducated private investors, encouraged by the media to benefit from sharp price rises – a classic sign of an asset price bubble.

Time for some respite?

A key question for investors is what happens now - will sharemarkets continue to head lower, or will there be some respite. Often, financial markets have a tendency to overshoot, as panic buying (as in a bubble) or selling (as in this case) drives asset values away from fundamental values. Dornbusch (1976) presents theory to explain this response in the foreign exchange markets.

There is some hope for a pause in the price decline. The cyclically adjusted price-earnings (CAPE) ratio, which provides an indication of over-/under-valuation of stocks on the basis of long-run earnings, suggests that Australian stocks are under-valued after the recent decline. Note that this is dependent on Australian firms maintaining earnings in what is a deteriorating economic environment.

It is also possible, that the US Federal Reserve will grant a reprieve to financial markets and not proceed with its well-flagged intention to begin raising interest rates in September. Market expectations of a hike have been sharply reduced in recent days. However, it would be wise to recall that the Fed has a history of looking through short-term market volatility when making interest rate decisions. (A good example was its decision to raise rates for the 11th consecutive time on 20 September 2005, despite concerns over the economic impact of Hurricane Katrina.)

In Australia, the All-Ordinaries index is close to the psychologically important 5,000 level. A common stream of thought is that levels ending in “,000” produce sharp movements once broken, often as a result of “stop-loss” order placement. However, daily closing prices for the All-Ords, in the period since 2000, show that when markets reach such levels there is often a pause for thought. Even in the aftermath of the Lehman Brothers’ bankruptcy in September 2009, the All-Ords hovered around the 5,000 level for 10 days before continuing its descent.

So we are likely to see a pause in the stock market decline for now. The question then is whether we see a continuation of the decline as in 2008/09, or whether this is just a correction before stock prices race higher as in the third quarter of 2011 (a move precipitated by the conclusion of the US debt ceiling crisis).

It may be that the Fed decision on 17 September provides the catalyst for a move in one direction. A rate increase and markets will head lower, a rate decrease and markets will be supported further.

What does it mean for Australia?

For Australian investors, corporates, and also government, the important aspect to glean from recent news isn’t the size of the sell-off in Chinese stock markets. Instead, it is evidence that the Chinese economy is slowing more quickly than predicted. An example of this is the Purchasing Manager’s (PMI) Index posting its largest decline since 2009, and indicating future growth will be even lower.

China’s slowdown has reduced demand for commodities at exactly the time that supply is increasing substantially. The result is sharply falling prices for a range of commodities including crude oil, natural gas, copper, and iron ore. Clearly, this has repercussions for an economy that is heavily dependent on exporting commodities, and it would not surprise one to find that the Australian stocks that have been hit most sharply are those with most earnings exposure to commodity prices.

Of course, this also has repercussions for the fiscal position of both state and federal governments. Perhaps as concerning is the state of turmoil gripping the federal government, resulting in a failure to acknowledge that a problem exists, never-mind suggesting ways of solving it.